One of the most confounding aspects of the bear market is the collapse of stocks that were seen as safe. I am not referring to GE, which was known to be playing games with its accounting and was selling at much too high a price, but specifically to utility stocks. The collapse would not have been a great surprise if investors had understood the extent to which utility companies had turned away from their conservative past and gone off in speculative directions. The stocks are down so much that they probably offer one of the best opportunities in the market, but figuring out how to act on the opening is difficult because the condition of the companies is up in the air.
With the arrival of de-regulation, utilities moved their plants formerly dedicated to the system into unregulated companies. Most set up trading departments whose inventory was their own power now available to be sold out of the system. After trading off much of their own production, they bought someone else’s as a substitute, creating a temporarily huge market in energy trading and a lot of short term trading profits. Once the initial swap-around was completed, they were left with little to do. As a result, trading departments are being abandoned or severely cut back. Left behind were trading “profits” using Enron type front loaded accounting for long term contracts, a decent portion of which are now uneconomic. The companies are now faced with writing off previously booked profits. The full extent of the losses is hard to guess, but may be substantial. Any losses could not come at a worse time because the companies are overextended in other areas and their financial condition has become precarious.
Under the stimulus of de-regulation, a lot of new capacity was built and old plants re-started, creating a surplus, and price weakness. This threatens outstanding trading contracts, leaving some companies committed to buying energy at a loss, and others to abandoning contracts. Bankruptcy at Enron and near bankruptcy at Dynergy, the most active traders, threw a monkey wrench into the contractural structure because many of the contracts in which they were involved are defunct because of being uneconomic. The regulated distribution function is required to buy the cheapest electricity on the open market (the concept behind de-regulation to begin with), leaving the companies as a whole with higher priced purchase contracts they had expected to sell into their own distribution. The surplus capacity created by a rush of new plant building based on forecasts of a rapidly growing economy places many plants on a marginal basis. Companies like Calpine were not been alone in the mad rush to build new facilities.
That is not all. Anxious to diversify, many plunged into foreign utility markets, often with unfortunate results. Desperately trying to get out to shore up their precarious balance sheets, many of the foreign operations are up for sale in a weak market. This means more writeoffs. TXU will take a $4.2 billion write off as it abandons or sells pieces of its U.K. operation for less than debt. That loss represented almost half TXU’s stockholder’s equity before a summer stock offering.
And then there is debt. As capital intensive regulated operations with limited return on equity, utilities have always been relatively highly leveraged. In the exuberance of de-regulation, and supported by the liberal conditions in the capital markets at the end of the 1990s, they borrowed to support the new directions, leaving them in a bind now that things have gone wrong. Analyzing the companies takes me back to my banking days. Good bank lending is short term in nature and based on the balance sheet, not the income statement. Utilities are still reporting good profits, though the outlook is questionable. It is the balance sheets that are in crisis. Write offs, of goodwill, of trading contracts, of assets already and to be sold, are inevitable. While these write offs can be seen as a clean up that will allow the companies to get back to selling electricity (it is amusing that they are now emphasizing their traditional operations), the losses are important for highly leveraged balance sheets. Many of the bond indentures have requirements for maintaining balance sheet ratios that will be difficult to meet (which is why they are dumping assets for liquidity). Indentures also call for maintaining a decent bond rating, which they are having trouble meeting. Most of the losses have yet to be taken, so the threat is growing. One major utility, Allegheny Energy, admitted to not being able to meet the requirements and more or less dared bondholders to do anything about it. Therein probably lies the eventual answer. It makes little sense for bondholders to put them into bankruptcy, for these are steady operations that will eventually work out of trouble. But eventually could take a while, and the threat complicates current analysis. Some of the stocks undoubtedly are selling way under their true value, but patience is needed until the picture is clearer. I expect a wave of year end write offs and some divisional bankruptcies (some already), after which sensible analysis may be possible.
One reaction of utility companies has been to flood the market with equity offerings without revealing the depth of the problems. Investment bankers have been up to their usual tricks, putting another one over on investors, and most of these offerings are now deeply in the red. Buyers should have been suspicious of massively dilutive offerings that made sense only if the companies were in trouble. Without the flood of stock offerings, there might already be blood on the street in a partial rerun of the telecommunications disaster. This makes the stocks all the more intriguing. Just think, some of the companies can be bought at 50% of what supposedly knowledgeable institutional investors paid in large quantities earlier this very year.
I made the mistake of buying some of these stocks for conservative investors looking for dividends when prices plunged. Allegheny Energy, for instance, was seen as a relatively conservative company whose stock was cheap and the dividend extraordinarily high. The problem for conservative investors is that many have cut their dividends, and more cuts are inevitable. Management has been swearing by their dividend, but reality is getting through. Longer term these will remain dividend oriented companies. As the smoke clears, yields over 10% should be available. This kind of return should lead to a doubling of the stock price.
In the end this is still a steady and needed business, and the problems will be worked out far more easily than with massively overcapacitied telecommunications. Measuring the affect of overcapacity is one of the current imponderables. Many partially completed plants will have to be finished, but everything possible has now been cut off.
Incidently, many of the new plants involve gas turbines made by GE. GE is booking cancellation fees and still delivering some turbines, but it is looking at the sudden cut off a business that has been a substantial contributor to profits in recent years. Between jet engines, gas turbines, and a squeeze on GE’s massive spreads in its financing operations from any increase in interest rates, GE’s earnings could be down sharply in a year or two. The braggadocio gushing from Immelt after he took over (he promised a higher growth rate than the already impossible rate achieved by Jack Welsh) never sounded right, and is becoming increasingly hollow. Will Jack ever cash in those 13 million plus options, presently worthless after having a value over $200 million two years ago?